Politics First on Student Loans

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The current debate over the student loan interest rates is a perfect example of how crazy our national politics have become. Leaving aside the differences in how Democrats and Republicans would pay for continuing this questionable subsidy, both parties are striving to appeal to students in this election year by keeping interest rates low while ignoring the economic reality that this move will further balloon student debt and could lead to higher tuitions as well.

How did we get to this perilous spot? The answer lies in the desire of politicians not to offend key constituencies no matter how much it might cost in the short run and no matter how little it may improve things in the long run. And keeping the interest rates low now makes it even more difficult to achieve the kinds of student loan reforms we need to put the system on a solid footing for the future.

This particular story begins in 2007 when a Democratic-led Congress and a Republican Administration agreed to halve the interest rate on those federal student loans in which the government pays the interest while borrowers remain in school, from 6.8 percent to 3.4 percent. As Rick Hess of the American Enterprise Institute has recently noted, some analysts warned five years ago that halving the interest rate would lead to complaints that loan burdens have grown too large and arguments that the lower rates must therefore be continued. Now that the time has come to renew or abandon the provision, those predictions are coming true.

Some of us also believe that the ready availability of student loans helps to explain why tuition levels continue to climb because it allows institutional officials to feel more comfortable that students and parents will be able to pay for these higher tuitions. Keeping rates low in the future will just continue this trend.

But when faced with questions about whether keeping interest rates low will help or hurt, both political sides are making some really silly responses. For example, Education Secretary Arne Duncan recently was asked about whether student grants and loans had contributed to the run-up in tuitions over time.

Here was his response: over the past 20 years, Pell Grants increased in some years and not in others while tuition had increased every year, therefore federal aid had not been a factor in the growth of tuitions. I happen to agree with the secretary that Pell Grants have not been that much of a factor in the growth of tuitions, although for a much different set of reasons. But looking at how many years aid went up or down is not a very cogent piece of analysis. It would not get a passing grade in my educational policy class.

But more tellingly, the secretary was silent about the possible impact of student loans on tuitions, where there is much stronger evidence of at least a correlation between amounts borrowed and prices and where the analogy to mortgages and the mortgage interest deduction affecting housing prices is hard to ignore. Do administration officials and other student loan advocates seriously believe that the awful amount of student debt in this country has absolutely nothing to do with increases in college charges?

Of course, the Republicans are doing no better on the honesty and consistency meter. The presidential candidate Mitt Romney recently blessed the Ryan budget – he called it marvelous. Yet it contained a provision not to continue the lower rate, and when push came to shove this past week, Romney said he supported the lower interest rate in order not to offend a key voting constituency in the fall.

As I argued in an earlier article on Inside Higher Ed, it is important for government officials to acknowledge that public policies have contributed to the growth in college costs and prices rather than just rip the colleges and universities. It's irresponsible for politicians to say this is all your fault -- we have had nothing to do with it -- when they enact policies such as keeping student loan interest rates well below market-clearing levels and then express surprise when borrowing continues to explode. .

The irony here is that the lower interest rate applies only to those federal student loans in which the government pays the interest while the borrower remains in school (the interest rate on non-subsidized loans is already at 6.8 percent). So keeping rates low during the in-school period has no effect on how much students pay while in school or how much it costs the government to make these loans, whether directly or in the form of guarantees to private lenders.

And a number of observers have pointed out that the change in the amount of monthly payments once borrowers leave school and start repayment is relatively small, yet this adds up to a $6 billion annual price tag. I would join other critics in arguing there are much better ways to spend this amount of taxpayer funds -- or use it to reduce the deficit rather than adding to it.

It is also worth noting that the U.S. is far from the only country pandering to students when it comes to loans and interest rates. New Zealand once had what some of us considered one of the best-designed student loan programs in the world, as it blended relatively low levels of government subsidy with repayment provisions that prevented graduates with low incomes from having to devote an unhealthy proportion of their income to student loan repayment.

But in two successive national elections in the 2000s, to win the votes of students, the liberal government there first eliminated in-school interest and then banned interest over the life of the loan. Now that a conservative government is in place, this benefit is viewed as sacrosanct. A similar history has unfolded in England, where substantial loan subsidies are distorting a series of higher education policies there, including the unwillingness of the government to let institutions expand beyond funded levels even with no additional government operational support.

Nor is the absurdity of our current politics limited to the interest rate issue. For example, the Obama administration asserts that everybody should have the opportunity to go to college and that we must increase college completion rates to remain globally competitive. But it doesn’t seem to realize that with no change in policies more people going to and completing college will greatly increase the amount of student debt, not reduce it. So the message is: “We are really worried about all this student debt but we think it is fine for people to keep borrowing because college on average is so valuable.”

The problem here is that not everybody benefits the same from going to college and that's how a lot of people are ending up with debt levels they cannot afford to repay. Income-contingent repayment policies, which I support, certainly help those students, but if anything they also add to the debt because there is less worry about the impact of high debt burdens.

The point here is that keeping the interest rate low, while it has many benefits, will also lead to more borrowing than if rates were higher. So we are trading even more debt for better repayment terms -- which may or may not balance out to mean lower repayment levels. Ultimately, we need to figure out ways not to require students to borrow more and more to go to college, which is why I think colleges and universities must have skin in the game, either by requiring them to share the risk by paying a fee on each loan that their former students fail to repay , or requiring institutions to provide discounts to their students who borrow so that borrowers are not paying the full sticker price.

This all suggests to me that what makes sense now because of election year politics is to get a one-year extension of the low rates with a promise to make student loan reform part of a much-needed review of Higher Education Act next year. And that review also must include a hard look at Pell Grants, where funding has tripled over three years and one out of two undergraduates now receives a Pell Grant. Rationality must at some point intercede if we are to make any sense out of our national higher education policies.